The Price Is a Blight

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When central banks adopted “quantitative easing” (printing money to buy financial assets) and other unorthodox means to buoy economies holed by the financial crisis, many feared that the result would be out-of-control inflation. Asset prices have certainly soared. But consumer prices have not. Indeed, the growing fear is that rich countries may be entering a twilight zone of ultra-low inflation.

A downward lurch has been most notable in the euro area, where annual inflation dropped from an already low 1.1 percent in September to 0.7 percent in October; a year ago it stood at 2.5 percent. It is now a percentage point lower than the European Central Bank’s inflation target of “below but close to 2 percent”. The ECB lowered its main policy rate to 0.5 percent in May; on November 7 its governing council, responding to the weak inflation figures, reduced the interest rate further, to 0.25 percent.

Elsewhere, too, inflation is low and falling. Almost five years after the Federal Reserve led the way with quantitative easing, inflation is well below the Fed’s 2 percent target (which relates to a somewhat broader measure of consumer prices than the better-known consumer-price index). In August this wider measure stood at little more than 1 percent. Across the G7 economies, inflation has been weak this year and has recently fallen back to 1.3 percent; a year ago it was 1.8 percent. Even in Britain, which has the highest inflation (2.7 percent) in both the G7 and the European Union, the rate has been broadly stable this year.

Slack energy prices have contributed to recent declines in overall inflation. That is a welcome development, boosting the purchasing power of both businesses and households. But core inflation, which by excluding the more volatile elements of energy and food offers a surer guide to underlying price pressures, tells a less heartening story. Across the G7 core consumer-price inflation has been stuck over the past year at 1.4 percent (see chart). On the Fed’s measure it is just 1.2 percent. And in the euro zone, core inflation has fallen over the past year from 1.5 percent to 0.8 percent, matching the record low of early 2010.

One bright spot that has helped to keep G7 inflation from falling further is Japan, where the reflationary drive of Shinzo Abe, the prime minister, is stoking hopes that the past decade and a half of deflation may at last be coming to an end. Overall inflation has risen to 1.1 percent — higher than in the euro area — and core inflation is now at zero. But the immense difficulty that successive Japanese governments have encountered in trying to escape the shackles of deflation serves as a warning of the danger of letting inflation fall too low. Once people start to anticipate declining rather than rising prices, it can be very hard to reverse their expectations.

Abandoning Reserve
That danger is less acute in the United States than in the euro area largely because the Fed is more proactive than the ECB. It surprised the markets in September by sustaining quantitative easing at its present pace of $85 billion of asset-purchases a month, rather than starting to curb it. A study by economists at the Federal Reserve, published last week, has fuelled speculation that it may keep interest rates at rock bottom even longer by lowering the level of unemployment at which it will consider rate increases from the current 6.5 percent.

By contrast, the euro area looks increasingly vulnerable to a slide into deflation. Although the region emerged this spring from a painfully protracted double-dip recession, the recovery is expected to be a feeble one. GDP will fall by 0.4 percent this year and rise by only 1.1 percent in 2014, according to forecasts from the European Commission published on November 5.

Such weak growth is unlikely to overcome the forces pushing inflation down. Output will remain well below its full potential next year, estimates the commission; all that idle capacity acts as a drag on prices. Unemployment across the euro area will stay stuck at a woefully high 12.2 percent, which will keep wages down. The strength of the euro will also exert a downward pull. It has been trading this week at $1.35, more than 5 percent higher than a year ago; on a trade-weighted basis it is 8 percent higher.

Very low inflation in the euro zone makes it much more difficult for uncompetitive countries, predominantly in southern Europe, to regain lost ground. Workers tend to resist nominal cuts in pay more fiercely than they do the subtler erosion of their income through inflation. If inflation in the countries with which the weak economies trade is high, they can improve their competitiveness simply by keeping their rate lower. That is in essence how Germany gained a big edge in the first decade of the euro.

But with overall inflation so low, peripheral countries must instead adjust through outright deflation or something close to it, meaning a freeze or absolute cuts in wages. Already, in September, when euro-wide inflation was 1.1 percent, prices were falling by 1 percent in Greece. They were flat in Ireland and rising by just 0.3 percent in Portugal.

A sustained period of deflation would be particularly hard on the euro zone’s periphery, weighed down by debt. Cyprus, Ireland, Portugal and Spain have high public and private debt; Greece and Italy have high public debt. When prices are falling, debt, which is fixed in nominal terms, becomes more onerous in real terms. Higher inflation, in contrast, makes escaping heavy debt much less burdensome.

Central banks have had to move beyond past orthodoxies in order to coax a modest recovery from the ruins of the financial crisis. Now, to avoid the blight of stagnating or falling prices, they may have to venture still further into unconventional territory.